Outlook for steel and economic growth in 2014 mapped against the location of major steel markets

In 2014, global steel demand is forecast to grow faster at about 3.3%. But despite the optimism, today’s tough economic conditions have led to a reassessment of risks, strategies and operations at each stage of the steel value chain.

“Steel producers should test the vulnerability of their business models and the resilience of their strategies to ensure sustainable growth.” - Anjani Agrawal, Global Steel Leader

Excess capacity is the biggest threat to the sector

While there are signs that the outlook for demand is slowly improving, excess capacity remains the biggest threat to the steel sector.

While some capacity is expected to be removed over the next decade, the announced addition of capacity by steelmakers out to 2020 shows that investment is still increasing rapidly.

To counteract the increasing levels of investment in steelmaking capacity, we estimate that about 300 million tons of steelmaking capacity needs to be closed over the next decade for the industry’s profit margin to reach a sustainable level, and raise capacity utilization rate for the sector globally from below 80% to more than 90%.

Increased competition will transform the market

Steelmakers are addressing numerous challenges such as volatility, shifting demand centers, complex supply chains, productivity and cost efficiency. As steelmakers increase their ability to survive in tough times, we will see increased market competition in nearly all products especially as there is a focus shift to high-value, higher margin steel products.

Increasing market competition will also result from the flatter marginal cost curve in the sector. With little difference between the positions of steelmakers along the cost curve, small changes in the operating environment, such as increased productivity or changes in cost of capital, can produce swift changes in positions, competitiveness and ultimately survival.

Steel companies who monitor and constantly create new sources of value are likely to be more successful.

As a highly geared sector, with limited access to capital, there will be increased pressure for 10%–15% of steelmaking capacity to close over the next two to three years. The knock-on effect will be:

An increase in M&A activity as stronger operators acquire their weaker competitors with the aim of rationalizing the sector

Early refinancing as steel companies seek to take advantage of low interest rates ahead of potential rate rises

Portfolio optimization as steelmakers assess their assets for value creation

The complex dilemma of where to allocate capital– whether capital should be invested upstream for raw material security or downstream to capture a greater share of the value chain

Preparing for demands of the future

The speed and degree of changes in the global economy and the increasingly complex interplay of factors influencing a more globally integrated steel business make horizon watching essential.

To succeed, steelmakers must determine how to optimize and create a new product mix and decide whether they are prepared to take the plunge to invest in new geographic markets.

As demand continues to shift to developing nations, the steel sector is directed toward China, with some focus on Brazil, Russia and India. As Africa becomes increasingly urbanized, it may be that the future scramble for African demand could completely shift the landscape in years to come.

Is 2014 the turning point for steel?

With a slightly stronger outlook for 2014 compared with 2013, and the promise of further progress in 2015 and beyond, the steel sector is focusing ahead to plan and profit from the opportunities and prepare for demands of the future.

This change will not be immediate and the centers of demand will vary. Nevertheless, the steel sector is expected to gradually gain momentum as the decade unfolds, with optimism about what lies ahead.

Planning to profit from opportunity

“A return to positive cash flows is encouraging for the sector, particularly with reference to its ability to service and refinance existing debt facilities. However, with higher interest rates mooted, tightening credit conditions remains a risk for those that haven’t yet refinanced their balance sheets.”- Lee Downham, Global Mining & Metals Transactions Leader, EY

Access to capital – limited funding options

Gearing in the steel sector is high, particularly compared with other sectors, and tight margins have reduced serviceability. A shift in the interest rate cycle is also expected in 2014 and, with it, higher funding costs for issuers.

How the markets deal with the timetable for the tapering of quantitative easing is critical. The impact will likely be felt beyond the US markets, with emerging markets having already seen significant outflows in 2013 and Asian investors fearing tighter borrowing conditions.

As a result, there is a risk that access to funding for steelmakers will be difficult particularly for those either in developed markets with high gearing or with a high exposure to volatile emerging markets.

In the first half of 2014, we may see early refinancing as steelmakers attempt to take advantage of low interest rates ahead of potential rate rises. Continued market volatility may limit the scope of steelmakers to issue bonds on the favorable terms of recent years. Pockets of confidence and yield seeking will continue but investors are likely to seek safety in investment grade names.

Alternatively, greater compensation on higher-risk, high-yield steel issues will be sought in the form of higher coupons, particularly given the sector’s exposure to emerging markets.

Capital raising by steelmakers 2011–13

Capital allocation – re-examining value

Rising pressure to service debt will see an increased examination of asset portfolios in the steel sector. Non-core divestments to release cash remain critical, particularly in light of negative free cash flows for most of the sector. However, a focus on extracting maximum value from the sector’s existing portfolios of assets remains important.

Successful players will optimize through re-allocation of capital within portfolios to those components most aligned with their strategy.

Despite a globalizing trend in steel business, the drivers of success may be different in different markets, creating demand for capital over varying investment horizons, scales and risk-reward ratios.

Decisions will have to be made about capital allocation between upstream or downstream operations and to sectors and geographies.

To meet their capital needs, steelmakers must extract as much value as possible from every capital dollar invested.

“The proliferation of the Chinese EAF production route will globally change the level playing field of ferrous metallic supply markets: more expensive scrap at the expense of cheaper iron ore.” - Pierre Mangers, Executive Director, EY

Steelmakers have largely responded to the challenge of raw material volatility and security of supply by vertically integrating their operations, whereas steel consumers appear to be using steel derivatives to mitigate this challenge.

Steelmakers need to understand their exposure at every stage of the value chain and implement risk management strategies to efficiently manage the exposure arising from the timing difference between the selling price (of steel) and the purchasing price (of raw materials).

Financial instruments - which ones?

Financial instruments have become an increasingly important alternative strategy to manage volatility in steel markets, with the recent price setting mechanism moving away from fixed contracts. The practice of using financial instruments to hedge both raw material and steel product price risks is not as prevalent in steel markets as it is in other commodity markets.

Prevalence of steel and raw material financial instruments

The market has identified the opportunity of using derivatives for steel and raw materials. As a result, a number of hedging instruments have come into play in recent years.

Iron ore derivatives remain the most traded and established of all ferrous derivatives, with steel derivatives being most active at the Shanghai Futures Exchange.

Opportunity lies in volatility

Another way steelmakers and steel consumers can address volatility is through better collaboration and communication. This would require steelmakers to become more customer-focused and respond to their customers’ desire for price certainty from order to delivery.

Steelmakers will need to know their customers’ plans and requirements as well as their own inventory cycles and steel distribution strategy. A derivatives-based strategy can allow producers to give pricing certainty to their customers and build out the cost of this into the price quoted.

This tool may indeed become a differentiator in attracting and retaining a long-term customer with a higher degree of mutual trust and confidence.

“The survivors in today’s steel market will have a better footprint in terms of market access, a more efficient cost curve and better access to raw materials, resulting in more efficient value chains. Increasing vertical integration of the steel value chain and diversification of product portfolio is a big question in today’s Brazilian market, as local players are still unsure of the right path forward...” - Carlos Bremer, Partner, Brazil, EY

For steelmakers, success depends on:

Being agile and open to change

Having access to raw materials

Changing the product mix

Achieving productivity gains

Picking a region or a sector they are best suited to

In terms of downstream industries or end consumers, as economic growth recovers, there will be increasing demand from the automotive sector in both emerging and developed regions. Nevertheless, infrastructure and construction will remain the largest steel-consuming sector, with manufacturing machinery set to play a role as well.

Looking upstream, the oil and gas sector will continue to experience significant capital investment over the next few years, which should drive demand for premium oil country tubular goods. These are all positive indicators that, despite the challenges of overcapacity, exchange rate fluctuations and pressure on margins, support the optimistic outlook for the steel sector.

Press

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.